Wednesday, December 12, 2018

There’s more than one path to $100 million

A couple of years ago I wrote a post titled “How fast is fast enough?”. The subtext of the question was “How fast do you have to grow if your ambition is to get to $100M in ARR and build a very large company”. It’s an important question, as your target growth rate determines your hiring plan, budget, and fundraising strategy.

In that post, I looked at how long it took publicly traded SaaS companies to get to $100M in ARR and concluded that if your goal is to reach $100M in ARR, you should try to get there within 7-9 years after launch. The thinking was that if you grow significantly slower, your chances of ever getting to $100M will go down. Meanwhile, a few SaaS companies have shown even more spectacular growth. Slack reached $100M in ARR just two and a half years after launch and Dropbox got to one billion dollar in ARR within ca. eight years. UIpath, the wildly successful robotic process automation solution out of Romania, is on a similar trajectory. But if you’re thinking that in light of these bar-raising success stories, I will suggest to further push up your growth targets, I have a little surprise for you. :-) I’m going to say the opposite – that you might want to consider a slightly slower pace.

To be clear, if you can pull off a “T2D3”, that’s fantastic. A SaaS company that gets to $2M in ARR within 1-2 years, triples in each of the next two years and doubles in each of the three following years is headed straight to unicornland. If you can do that without burning hundreds of millions of dollars along the way (or even hitting a wall), go for it. The crux is that this is a pretty big „if“.

Setting yourself up for T2D3-style growth usually comes with a very high burn rate – hundreds of thousands of dollars per month, eventually likely millions, depending on where you’re at in the journey. The main reason is that your customer acquisition costs are highly front-loaded. While this is generally true for most companies, it’s particularly true for SaaS businesses, which invest heavily in product development, sales, and marketing upfront and get payments from customers over a delayed period of time, usually several years. Let’s say you have a CAC payback time of 12 months, i.e. your fully-loaded customer acquisition costs equal 12 months of gross profit. If your customer lifetime is, say, four years, this means that the gross profit from the first year pays back your customer acquisition costs, and the gross profit from the following three years can be used to cover your fixed costs and eventually create profits. Not bad.

What makes things tricky is, first, the uncertainty of how your CACs will develop at increasing scale and of how your churn rate will develop over time. As I wrote here, trying to forecast what happens to your CACs if you 10x your sales and marketing spend is very difficult. The second issue is the timing of some of the major expenses. If you close a mid-market or enterprise customer today, it usually means that a salesperson, let’s call her Maria, has been working on the deal for 6-12 months. Maria probably required at least three months of onboarding and training, and chances are that three months before Maria’s first day at your company you paid a recruiter (or incurred other types of recruiting expenses) to find her. Presumably, you also increased your marketing budget to generate more leads 6-12 months before Maria closed that deal.

In other words, if you want to meet your Q1/2020 targets, you will likely start incurring costs related to these targets very soon, a year before you start to generate cash, and two years before these investments start to become ROI positive. That enormous lag time (which the always excellent David Skok calls the SaaS Cash Flow Trough) makes it hard to course correct if things don’t go according to plan. Like a large tanker at cruising speed that cannot quickly take a turn, a startup with a fast-growing headcount and a high burn rate loses some of its ability to quickly react to new information, new insights, or changes in the market.

If you’re setting yourself up for hypergrowth, the margin for error is very thin. If you’re highly confident in your PMF and the scalability of your sales and marketing machine and you’ve raised enough money to survive a few missed targets, go for it (but keep a very close eye on pipeline coverage, quota attainment, and other leading indicators). If, however, you’re less certain or you have a smaller war chest, consider going a little bit slower.

One way to sanity check your budget is to simulate what would happen if your costs grew as planned while revenue increased only linearly, i.e. you assume that you’d keep adding the same amount of net new ARR in the next quarters that you’ve added in the last quarters. Let’s say you’ve grown from $6M to $18M in ARR in 2018, perfectly in line with the T2D3 mantra. Let’s assume you’re planning to double in 2019, from $18M to $36M in ARR, while burning around $20M (so you’d burn about $1.10 for each $1 of net new ARR, which is quite healthy). Now imagine that you’re spending money as planned, but instead of adding $18M in net new ARR in 2019 you’re adding only $12M, the same amount that you’ve added in 2018. As a result of missing your revenue target by 33% (or just 17%, if you want to fool yourself and calculate target achievement based on ARR as opposed to net new ARR), you’ll burn around $6M more than planned (the precise amount depends on your payment terms). I’ve created a very simple model that illustrates this.

As you can see, if you’re hiring for T2D3 growth but you end up growing revenue somewhat slower, the gap between your revenues and your costs will widen very quickly, which leads to a double whammy: Your runway shortened because you’ve burned more than planned, so you’ll have to raise again sooner, and at the same time your growth rate went down, which makes it harder to raise more money. In a situation like this, two or three missed quarters can be life-threatening if you don’t have enough cash in your war chest. Because of this, make sure that whatever path you choose, all key stakeholders (co-founders, board, investors, leadership team) are aligned on the plan and potential fallback scenarios.

The good news is that growing a little slower is not the end of the world. If you have a great product with high NPS, low churn, and an excellent position in your market segment, you have a decent chance of getting to $100M in ARR even if your growth rate starts dropping significantly below 100% y/y at around $10M in ARR. It just takes a few more years, but hey, $100M in ARR is cool even if it takes 10-12 years instead of 7-9, isn’t it? :)

Giving yourself one or two more years to get to $100M has an enormous impact on the required growth rates. You can see this if you play around with the numbers in this little calculator that lets you calculate how fast you have to grow in order to reach $100M in ARR within different time spans. Besides a linear and an exponential growth model, it also shows what Rory O’Driscoll called the “Mendoza Line of SaaS growth”, a very interesting concept which assumes that your growth rate for any given year is likely around 80 percent of your growth rate in the prior year, which is a more realistic assumption than having a constant growth rate.

Now, what does the data tell us, are there any (or many?) SaaS companies that took a few extra years to get to $100M, or is it “T2D3 or bust”? I looked at more than 60 SaaS companies to answer that question, but I realize this post has already become much longer than planned, so with apologies for the cliffhanger, let me save the answer for a followup post that is coming very soon. :)